Philippines - Agriculture : issues in pricing policy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 4845-PH COUNTRY SECTOR REPORT PHILIPPINES AGRICULTURE: ISSUES IN PRICING POLICY (TWO VOLUMES COMBINED) VOLUME I EFFECTS AND ISSUES OF GOVERNMENT INTERVENTION VOLUME II ANNEXES July 10, 1984 Projects Department, Agriculture Division II East Asia and Pacific Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed 'itiout World Bank authorization.  CIJRRENCY EQUIVALENTS Currency Unit = Peso (f) P 1.00 = US$0.07 US$1.00 = P 14 P 1,000,000 = US$71,429 WEIGHTS AND MEASURES Metric System ABBREVIATIONS CCSF - Consolidated Coconut Stabilization Fund CIDF - Coconut Induetry Development Fund CIIF - Coconut Industry Investment Fund COCOFUND - Coconut Fund DRC - Domestic Resource Costs EPR - Effective Protection ]Rates FPA - Fertilizer and Pesticide Authority GOP - Government of the Philippines NASUTRA - National Sugar Trading Corporation NEPR - Net Effective Protec-tion Rates NFA - National Food Authority NPR Nominal Protection Rates OER - Official Exchange Rate PCA - Philippine Coconut Authority PI-HILSUCOM - Philippine-Sugar Commission PTA - Philippine Tobacco Authority PVTA - Philippine Virginia Tobacco Authority SER - Shadow Exchange Rate IJNICOM - United Coconut oil Mills  FOR OFFICIAL USE ONLY AGRICULTURE IN TRE PHILIPPINES: ISSUES IN PRICING POLICY Volume I Effects ar.d Issues of Government Intervention Table of Contents -~~~~~ Page No. SlMMARY AND RECOMMENDATIONS .....*... . ... ..... CCe C *e * *v *, . i-v Is INTRODUCTION ................ *,,...... 1 A. 'Preamble .. ....... ....... * I B. Objectives of Government Intervention , 2 C. The Agricultural Sector t.3 II. CONCEPTS AND NETHODS OF ANALYSIS ....................... 4 A. Border Prices as Reference Points ....................... 4 B. Nominal Protection Rate .... ....... 4 C. Effective Protection Rate .. .. .. ... ... 5 D. Net Effective Protection Rate .......................... 5 E. The Winners and Losers of Government Intervention 6 F. Domestic Resource Costs *.. *. * - C ...... O*e,* *, 6 C. Limitations of the Ana l y s i s 7 UII. MAJOR INTERVENTIONS IN AGRICULTURE: THE PRESENT POSITION.... 8 Ai Macro Policy Instruments . . . . . . . . . . ......*..................... a . The Exchange Rate and the Trade Reeim e 9 2. Industrial Policy. ........ ......... 10 B. Product-Specific Interventions ................. 11 1. Ricie 11 2. Corn 13 3. Sugar. ..... . 13 4. Coconut .* 14 5. Wheat ........ ...... 15 6. Livestock ............. * 15 7. Fertilizers ....16 8. Farm Mechanization 17 This report was prepared by a review mission which visited the Philippines in April 1983; it draws heavily from the various studies of "The Impact of Econo- mic Policies on Agrl'culture," funded by the Philippine Institute of Develop- ment Studies and the Philippine Council for Agricultural Resources and Research. The mission consisted of Wayne Ringlien (Mission Leader), Malcolm Bale, Donald Mitchell, Peretz Ram (Bank) and Cristina David (Consultant). This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Page No. IV. EFFECTS OF GOVERNMENT PRICE INTERVENTION IN AGRICULTURE...... 18 A. Nominal Protection of Agriculture ..... .................. 20 B. Implicit Tariffs on A3ricultural Inputs ................. 22 C. Effective Protection in Agriculture .... ................. 23 D. Not LAfective Protection in Agriculture ................. 26 E. The Merchandise and Fiscal Effects of Government Interventions .......................... .... 27 F. Competitiveness of Philippine Agriculture ............... 32 V. ISSUES AND RECOMMENDATIONS IN PRICING POLICY AND HARKETING INTERVENT'ION ............ , . ,.* .......... 35 A. Macro-Policy Recommendations............................. 35 1. Policy Making Apparatus ............................s * 35 2. Incentives and Interventions .......................... 35 3. Long-run versus Short-run Policies ................... 36 4. Price Stabilization .a. ..... * ............* 37 B. Micro-Policy Recommendations *.99 o*........... . .*...... 37 1. National Food Authority.....-. ... .. . . ....*. . 37 3. Soougar . . . . . . . . . . . . . .~ . . . . . . . . . . . . . . . . . . . . . . . *. . . . . . . . ........................................38 3. Sugar .. 9....... 38 4. Fertilizer and Pesticide Authority.........6e......... 38 5. Credit Subsidies... ............. 38 TEXT TABLES Table No. 1. Government Interventions and Intervention Agencies by Product and by Instrument .......................... 19 2. Trends in Nominal Protection Rates of Agricultural Commodities, 1960-82 ...........99....... @ 20 3. Implicit Tariffs on Agricultural Inputs, 1980-81 .......... 23 4. Effective Protection Rates for Major Agricultural Products, Agroprocessing and Manufacturing ............ 24 5. Average Effective Protection Rates for Major Industry Groups ....... ,. 25 6. Estimated Effects of Agricultural Price Interventions on Selected Commodities, Annual Average 1979-81 ....... 28 7. Estimated Effects of Agricultural Price Interventions and Use of a Shadow Exchange Rate on Selected Commodi- ties, Annual Average 1979-81 ............... . 31 8. Domestic Resource Costs for Major Agricultural Products, Agroprocessing and Manufacturing .. .....*..... 33  - Iii - AGRICULTURE IN THE PHILIPPINES: ISSUES IN PRICING POLICY Volume II ANNEXES 1-10 Table of Contents Page No. ANNEXES 1. A PROFILE OF THE AGRICULTURALSECTOR............................ .1 2. ESTIM4ATING PR0'IECTION ..... .. . a..... a , , a as, 7 3. AN EXPLANATION OF TH{E WELFARE ANALYSIS .......................... 11 4. NATIONAL FOOD AUTHORITY .......... . ....................... *. 15 5. FERTILIZER AND PESTICIDE AUTHO RITY . .............22 6. PRICE STABILITY .. . ......................... . 24 7. INTEREST RATE SUBSIDIES .................... s,, s.... ....... 27 8. PRODUCTION RESPONSE TO PRICE AND TECHNOLOGICAL CHANGE.......N.G. 30 9. LIVESTOCK-FEED RELATIONSHIP..A.. I O NS.... ..a..............a 35 10. BIrLIOGRAPHGY.- .. ......... .. .. .... 37 11. SUPPORTING TABLES AND FIGURES ....... ........aa.... 39  - i - SUMMARY AND RECONMNDATIONS 1. This study reviews the impact of government market interventions on the performance of the agricultural sector over the past 10-15 years. "Interventions" cover both general (economy-wide) and crop-specific policies, programs, and institutions that influence the prices farmers receive and, in some cases, the prices consumers pay, for agricultural commodities. Types of interventions examined include: the procurement policies of national marketing agencies; the pricing of agricultural inputs such as fertilizer, credit, and irrigation; the taxation of agricultural exports and the protec- tion of agriculture through duties and quotas on imports; and the control by state agencies of exports and imports of certain commodities. Attention is also given to the overall foreign-trade regime and to whether there has been any bias in the Impact of exchange-rate policy on agriculture and industry, respectively. 2. In assessing the impact of the Government's market interventions, the study concentrated on six major commodities--rice, coconuts, sugar, corn, hogs, and poultry. "Impact" has been measured by making quantitative estimates, with and without the interventions, for each of the six commodi- ties, with respect to the levels of: i. output; ii. consumption; iii. exports and imports; iv. government revenues; v. foreign exchange earnings; and vi. employment. An assessment was also made of the welfare gains or losses of producers and consumers, and the size of the "net deadweight loss" on the economy. 3. Quantitative estimates of the kind described require use of a with- and-without methodology that compares what actually happened with what would have happened under a regime of little or no government interventions, so that producers and consumers are free to sell or buy in either domestic or foreign markets. This approach provides a useful standard against which the effects of interventions can be measured: divergences between the two are regarded as "distortions," implying that the economy would be better off if the interventions were removed or reduced. The approach is in useful suggesting general directions in which policy and programs should move; however, there are enough limitations to advise caution before accepting the results as "actionable recommendations," particularly recommendations that apply to crop- specific interventions as distinguished from general macro-economic policies (e.g. the relative levels of protection given to industry as compared to agriculture, and the level of interest rates). Regarding specific commodity interventions, the conclusions in many cases need to be tested by more detailed studies.  - li - Principal Findings 4. The agricultural sector has generally performed well with respect to growth of output. Only sugar, cocoa, abaca, and tobacco have grown more slowly than the impressive 4.5% average rate achieved by the sector in the 1970s. The growth in rice production has been particularly impressive, reflecting the heavy investments in irrigation, the spread of high yielding varieties, and increased fertilizer use. 5. Good overall sector growth has occurred despite the fact that macro- economic policLes have favored industry and penalized agriculture. The pro- Industry "tilt" in macro-policies has reduced the relative incentives and rewards in agriculture; the results have been to shift resources out of agri- culture somewhat faster than would otherwise have occurred; it also encouraged fewer exports than would have occurred under a more neutral set of policies; and generally held down the returns to land, labor, and capital in the sec- tor. In addition to these effects of macro-economic policies, commodity-spe- cific policies on export taxes, export quotas, and parastatal control of marketing appear to have undervalued agricultural prices, particularly of sugar and coconuts. 6. With respect to agricultural exports and imports, both have increased at roughly the same rate over the past 10-15 years. Exports have continued to exceed imports by about two and one-half times. This is not as strong a sectoral balance-of-payments performance as one would like to see in a country with favorable land, labor, and climatic advantages in tropical agriculture; one would have hoped for a faster growth in exports and a slower growth in imports. The review identifies some interventions which may partially account for the sector's rather indifferent export performance. 7. The Government's policy goals have been to promote industrial- ization, provide food and raw materials at low prices, and to minimize price instability. Low prices could result either from a continuation of the low- productivity/low-wage situation that has traditionally characterized much of Philippine agriculture, or from technological changes that gradually move farmers into higher-productivity/higher-wage activities. One efi-,ct of the industrial "tilt" in the structure of macro-incentives has been a weakening of private incentives to make the investments necessary to raising agricultural productivity. 8. The National Food Authority (NFA) has been given monopoly power to import feedgrains, soybean meal, and wheat and to export rice. Creation of its predecessor, NCA, was in response to the turbulence in world grain markets during the world food shortages of the early 1970s. This intervention appears to have stabilized the price of traded commodities at levels somewhat higher than would have prevailed if this trade had been left in private hands. These higher-than-private margins reflect additional costs which the econony must pay. The estimated cost of subsidies covering NFA operations during the 1977- 82 period is P 4.4 billion (about US$600 million) in current prices. These additional private and public costs may be regarded as the cost to the economy of whatever degree of price stabilization NFA has been able to achieve. Whether the cost of this "trade-off" was large or small can only be determined by the kind of study recommended i.n para. 13 below.  - iii - Recommendations: General 9. There are two general recommendations that come out of this review. One is that the Government should adopt macro-economic policies that are not so heavily stacked in favor of industry. Important steps have already been taken in this direction by lowering Industrial tariffs. The other is that Government should give stronger emphasis to the development and introduc- tion of new technologies that raise productivity and lower costs for key com- modities and should rely less on market interventions designed to influence p:rices. A move towards greater liberalization of domestic and foreign tradie in agricultural products need not mean the dismantling of existing institu- tions and programs; but it does mean sone relaxation of intervention and greater reliance on competitive market forces as the main determinants of prices, and it also means that a clearer separation between the regulatory and trading 'unctions of the parastatals is needed. Recommendations: Specific 10. Poultry and corn: Poultry production is receiving more protection than it needs in order to earn reasonable returns (poultry meat has a high import duty). The results are unnecessarily high prices for consumers and insufficient pressure on producers to adopt improved technologies that would lower their costs. Some reduction of the poultry duty has already occurred; f.urther reductions now seem justified to reflect, and to encourage, cost- reducing changes now occurring in the industry. While corn prices in the past were higher than corresponding import parity prices, domestic prices were kept lower in recent months than world market prices. The corn price, critical to the feed industry, should reflect competitive prices of international trade more than it does under the NFA trade monopoly arrange-lent. II. Feed and livestock industries: Market interventions governing the import of corn and soybean meal kept the price of poultry feed in the past at least 20% higher than it would have been if these key ingredients could enter at world prices (feed costs account for about 70% of the total cost of raising poultry). Hog and cattle growers would also be helped, but less strongly since fodder and wastes play a much larger role in their rations. If these first two recommendations are adopted, we believe Philippine corn, poultry, and hog producers could become competitive with other cotuntries and could participate in the region's expanding trade in these commodities. Soybean production is not well suited to the Philippines and therefore does not justify infant-industry protection. 12. The fertilizer industry: The country does not have sufficient oil and gas to produce nitrogenous fertilizer and other agricultural chemicals at costs that can compete with imported products. The domestic industry can therefore exist only if it is protected, forcing farmers to pay higher prices and/or imposing subsidy costs on the national budget. Time has eroded the original justification which led, in 1973, to the establishment of the Fertilizer and Pesticide Authiority, intended to protect farmers from the high energy cost; and fertilizer prices of the first oil shock. With the changed world energy picture, the Government now finds itself protecting a domestic nitrogen fertilizer industry that has become non-competitive. A strong case  - iv - exists for exposing the domestic fertilizer industry to more competition and for permitting Philippine farmers to gain access to agricultural chemicals (including fertilizers) at world prices. Just how such a shift toward liberalization should be structured and timed deserves a special study (one that should compare Philippine experience with the similar experience of Korea, Japan, and other Asian countries). 13. Reconciling price stability and private trading: The achievement of price stability for key crops involved the creation of a government apparatus whose costs are considerably higher than those of private traders and which has a tendency to expand in search of additional revenue. There is therefore a strong case for minimizing the burden of higher costs of government opera- tions and for leaving as much as possible of the procurement and distribution functions in private hands. Both of these objectives can be realized if Government, as a matter of policy, limits its interventions to assuring floor prices for producers and ceiling prices for consumers. This can be done through government procurement, stocking, and release nrograms that operate flat the margin" for key crops - i.e. by purchasing and later releasing rela- tively small proportions of a crop only when prices reach extreme values. The danger of unjustified extra costs arises when bureaucracies become inflated and attempts are made to finance these costs by giving procurement agencies monopoly powers or when domestic procurement policies set ceiling prices that make private margins too narrow which forces commodity trade through government channels. For example the NFA monopoly role in foreign trade should be ended by permitting private trade. As the basis for adjusting the present structure of NFA interventions, an in-depth study of NFA policies and programs should be undertaken. One major focus of such a study should be the impact of NFA programs on low-income rice and corn farmers. 14. Rice quality and rice exports: The success achieved in expanding rice production is now widely recognized. Except for bad years, the country is expected to have surplus production for the next decade o- more; this surplus opens the possibility of rice exports if the quality of rice can be improved. The high proportion of "brokens" persists primarily because of the insulation of domestic from world market standards as a result of the Government's monopoly control over exports and imports. Domestic price ceil- ings are one of several factors that have weakened incentives to invest in new milling plants and equipment. Neither the official nor the market price structures provide any incentive to produce rice with a low percentage of brokens. Allowing private exports would, over time, likely be the most cost- effective way to raise milling standards to export quality. NFA has recently announced that private trade in rice exporting will be permitted, a move the Bank warmly welcomes. Private trading could run parallel to continuing NFA market activity; it is also compatible (as in Thailanl' with government-to- government contracts.  - v - 15. Profit levels in sugar milling and coconut processing: Profits in sugar milling appear to have been held down by government interventions whichl have resulted in the industry receiving, on average, less than the world price of sugar. This has been aggravated by a domestic price policy which in the 1970's has subsidized consutmers at the expense of prod"cers, and a revenue sharing formula which results in part of the returns from investments by mills in improved sugar extraction going to planters. Consequently, investment to upgrade older plant has been inhibited. In coconut, there has been excessive investment in new plant as a result, among other things, of Board of Investment incentives in the 1970's. The costs of the parastatal institutions created to assist these two industries and margins of the selling agencies appear high, while convincing strategies for industry development are lacking or not public.  - 1 - I. INTRODUCTION A. Preamble 1.01 Despite tihe strong industrialization bias in the postwar development strategy of tile IPhilippines, agriculture still dominates the economy in some important respects. Seventy percent of the population are located in the rural areas. Agriculture employs about 50% of the total labor force and con- tributes nearly 30% of the net domestic product. Wien all economic activities reJated to agricultural processing and supply of nonfarm agricultural inputs are included, the agriculttural sector, broadly defined, accounts for at last two thirds of the labor force and one-half of the net domestic product in the economy~ About 40% of total export receipts are also earned from raw and pro- cessed agricuLtural products. 1.02 It is, therefore, not surprising to find that government policies toward agriculture are quite pervrasive and comprehensive. In addition, there has been a growing involvement of Government in the direct operation of the agricultural complex in the Philippines over the last decade. Typical policy instruments affecting farmers' prices (and therefore incomes) are price controls, export taxes, import tariffs or quotas on inputs, direct subsidies (credit) and indirect subsidies (water charges), procurement policies of national marketing agencies, investment in agricultural research and develop- ment and its transmission to producers, and land tenure arrangements. In addition, some national and other sectoral policies that may not seem to have an immediate or direct influence on agriculture do in fact profoundly affect the profitability of agriculture. 1.03 The purpose of this study is not to question the legitimate role of Government in regulating or directing the agricultural sector in the Philip- pines. Rather, its aims are to report on the types of policies and interven- tions in agriculture used by the Government, to analyze their implications and to calculate their effects on the major products and inputs and on the income and welfare of the producers. In addition some other possible bottlenecks to agricultural growth are identified. In the Philippines, policy-making in the agricultural sector has been fragmented or compartmentalized. Policy decisions made within an agency or ministry are not always viewed in the broader context of their effects on the total economy. This report does not focus on the short-run and temporary problems now faced by the Philippines, btut is concerned with the medium- to long-run evolution of agricultural policy. Therefore, its recommendations, including short-term ones, are designed to be consistent with long-run objectives rather than to respond to what we view as current transitory problems. 1.04 This report is divided into five sections. Following a statement on the objectives of government policies and the characteristics and recent per- formance of the agricultural sector, a chapter is devoted to defining the concepts and explaining the method of analysis used in the report. The third chapter presents the current policy environment faced by agriculture in terms of the major interventions undertaken by the Government  - 2 - of the Philippines (GOP).-1/ This refers to both crop-specific interventions and macro-policy instruments employed more generally than in the agricultural sector alone. Using the tools outlined in the second chapter, the fourth chapter quantifies the effects of government intervention on output, effi- ciency, government revenue, and other parameters by crop and in total. Finally, the fifth chapter presents a series of issues and recommendations considered by the mission to be importani: in order to improve the performance of the sector. Much of the detailed explanatory materi&l is relegated to Annexes. Details of policies and justification or proof of the positions taken will be found in Volume II or in the supporting documents cited. i.05 This work builds on sector work on the Philippines already under- taken and completed by the Bank: these include The Agricultural Credit Sector Review, May 12, 1983 (Report No. 4117-PH); Irrigation Program Review, December 15, 1982 (Report No. 3545-PE); Sector Operations Review: Agriculture and Rural Development Program in the Philippines, February 10, 1982 (Report No. 3796); Aspects of Poverty in the Philippines: A Review and Assessment, two volumes, December 1, 1980 (Report No. 3545-PH); and Grain Production Policy Review, two volumes, January 22, 1979 (Report No. 2192a-Pli). Also it draws heavily on studies by researchers in the Philippines. These are cited throughout. B. Objectives of Government Intervention 1.06 Whenever a government implements a policy or takes a policy action it influences the economic environment which shapes the behavior of producers and consumers. Thus "government intervention" is a generic term given to any government action that alters the incentive structure of an economy. It therefore includes actions such as taxes, tariffs, quotas, subsidies, special concessions, restrictive rules and regulations, foreign exchange controls, price setting, and the establishment of parastatal marketing organizations. Since alterations of the incentive structure wi'll uasually benefit some segments of the population but have a negative impact on others, and since goverrments have a legitimate role in making and implementing policy, no judgment on whether government intervention is "good" or "bad" can or should be made on an a priovi basis. Thus the term "government intervention" as used here is free of any pejorative meaning. 1.07 The apparent objectives of Government market intervent.on in agriculture in the Philippines have been to accomplish three basic goals: (i) to maintain relatively low food prices to consumers; (ii) to provide a relatively stable price to rice and corn farmers; and (iii) to accelerate the process of industrialization. 1.08 Industrialization has been the central thrust of the Philippine development strategy since the 1950s. With a relatively high man-land ratio, industrialization was considered to be a key to modern economic growth and the 1/ "Current policy" refers to policy in place at tne time of the mission's visit to the Philippines (in April 1983).  - 3 - more productive employer of the growing labor force. Agriculture was viewed simply in a supporting role to supply foreign exchange, cheap food, inexpen- sive raw materials and capital resources for this effort. Given the past development and pending reforms in the. industrial sector, greater emphasis is now being placed on achieving improven performance in agriculture. C. The Agricultural Sector 1.09 Agriculture is the largest sector in the economy of the Philippines. It employs over 85% of the employed rural population, and accounts for about half the total employment in the country. Crop production, particularly rice, corn, coconuts and sugarcane, is the major enterprise, accounting for 58% of gross value added in the sector. In 1983, livestock and poultry contributed 18%, fisheries 17% and forestry 7%. Agriculture is characterized by small units, farmed by families, some of whom hold their land as tenants. Productivity is typically low and when combined with land scarciLy results in low incomes. The average family income in rural areas is about 75% of the national average and income distribution within the sector is highly skewed. 1.10 The private sector plays a dominant role in agriculture, but the public sector plays an important role in a few areas, such as research and extension, setting prices on basic commodities, marketing of certain crops and the provision of about one third of rural credit. The predominant unit of production is the small, privately owned, owner-operated farm. Tenancy is found on approximately one third of the farms. The private sector produces, imports and distributes farm inputs and also plays a role in purchasing, processing and distributing farm produce. Within Government, responsibility for the agricultural sector is divided among several ministries and many other institutions and agencies which are not necessarily under the direct control of the principal sector ministries. Some 15 agencies provide varying forms of extension services and at least eight agencies have a role in irrigation projects. 1.11 Although there has been considerable variation by _bsector, the trend growth rate of agriculture as a whole was a respectable 4.5% during the last ten years. The Philippines has switched from a rice importer to an exporter in 1977 and has maintained this position during the last six years. Production of fish, pork and poultry has expanded rapidly. Coffee and rubber production rose by over 10% per year from 1970 but from a small base. Among other internationally traded crops, cocoa production fell, abaca and tobacco production stagnated, and sugar production rose less than 2.5% per year. Growth in the production of coconut, the country's major export crop, is difficult to assess because of discrepanciese in the statistical series. How- ever, the cocorlut producing area grew at some 5% p.a. over the decade. Export of both dessicated coconut and coconut oil posted annual gains averaging about 5% and 13% respectively over the last decade. Banana and pineapple exports also rose over the decade. 1.12 The contribution of agriculture to total ex,urts has fallen from 84% in 1965-67 to 50% in 1978-80 and 40% in 1982. In 1969, forest products were the most important export group (30% of total) followed by coconut products, sugar and mineral products (each with about 19%). By 1982, coconut products  - 4 - were the most important agricultural group, but accounted for only 12% of the national total after manufactures (46%) and minerals (12%). Sugar accounted for 9%, forest products 7%, and fruits, vegetables and all other agricultural exports combined (fish, tobacco, abaca, coffee, rice) represent2d a total,of, 11%. Betwe27 1972 and 1982 the share of the sector in GNP fell from about 28% to 22%.- II. CONCEPTS AND METHOD OF ANALYSIS A. Border Prices as Reference Points 2.01 In order to measure and evaluate the effects of government interven- tion through the pricing mechanism, it is necessary to have a reference point. A commonly accepted reference point is the price regime that would prevail in the absence of any government intervention. In the absence of government interventions, prices of traded or tradeable goods in the economy would equal the price of the same goods on international markets adjusted for locational and quality differences. This is referred to as the border price of the good and it represents the opportunity cost to the country of the com- modity whether imported or exported or whether It is a potential import or export. Once a set of border prices and domestic prices for each commodity at the same point in the marketing chain is assembled, it Is possible to construct three measures of the degree to which domestic and border prices diverge. B. Nominal Protection Rate 2.02 The first measure is the nominal protection rate (NPR). It is simply the difference between the domestic and border price of each commodity expressed as a proportion of the border price, where the border price is con- verted into domestic currency at the official exchange rate. That is NPR = x 100 where Pd = domestic price Pb = border price NPRs may be positive (when the domestic price is higher than the border price) indicating that the commodity is protected or they may be negative (when the domestic price is lower than the border price) indicating that the commodity is "taxed" or "negatively protected." Alternatively an NPR equal or close to zero indicates thlat the commodity is neither directly protected nor taxed. 2/ See Annex I of Volume II for an introduction to the Philippine agricultural sector including characteristics of the sector, its structure and performance. A more complete treatment of the sector and the Bank's role in its development can be found in Bank Report No. 4318- PH entitled Philippines, Agricultural Sector Memorandum, May 10, 1983.  2.03 NPRs are used in this study merely to show how agricultural protec- tion has changed over time. The other measures used provide a more accurate assessment of the degree of protection. C. Effective Protection Rate 2.04 The second measure of protection is the Effective Protection Rate (EPR). This measure takes account of the fact that intermediate inputs in the production process may be overvalued or undervalued by government interven- tions and thus may distort the level of protection calculated using NPRs. Thus the effective protection rate is defined as: EPR Vd - Vb EPR Vb x100 Where Vd = value added evaluated using domestic prices; Vb = value added evaluated at border prices (converting the latter into domestic prices at the official exchange rate) Value added is defined as the value of output at any point in the production process less the value of the purchased inputs, with prices expressed in domestic currencv using the official exchange rate for imported inputs. It now becomes apparent how NPR and EPR differ. The EPR measure allows for the fact that the domestic price of inputs into the process may differ from their border prices and therefore affect the margin (value added) of the process. Like NPRs, EPRs can be positive, negative or zero. A high positive level of effective protection encourages expansion of the coimno ty while a negative one discourages production. An effective protection rate of approximately zero has a neutral output effect. EPRs are useful in policy analysis because they provide a good comparison across commodities of the net effect of various price interventions in the product and input markets. A comparison of EPR's will provide an indication of the direction of resource flows both within agriculture and between agriculture and other sectors of the economy. D. Net Effective Protection Rate 2.05 The third measure of protection used here is the net effective rate of protection (NEPR). This is the EPR corrected for the e1inated overvalua- tion of the exchange rate resulting from the trade regime._ The basic premise for making calculations of NPRs and EPRs is that the prices of goods and resources in the presence of distortions and government interventions do not reflect the true social costs and benefits i.e. "social prices" of the 3/ This report does not deal with the management of the official exchange rate from the viewpoint of its appropriateness for maintaining viability in the current account.  - 6 - goods. The exchange rate is the price of domestic currency in terms of another currency, and that price also can differ from Its "social price" i.e. the "shadow" exchange rate. The latter is the rate of exchange calculated to prevail in the absence of trade interventions or under an "optimal" trade regime. In the calculation of NEPR the shadow exchange rate rather than the official exchange rate is used in the valuation of traded inputs and outputs. 2.06 The unique contribution of the exchange rate as an incentive or disincentive to production can be measured by comparing the difference in protection offered to a product or an industry when calculated using the EPR and the NEPR. This is the reason that both calculations are made in this report. In Annex 2 of Volume II the methods of estimating protection are presented in further technical detail. E. The Winners and Losers of Government Intervention 2.07 The analysis of the effects of intervention on product prices may be extended by measuring the effects of price changes on production and consumption and by calculating the reallocations of income that result from intervention. In short, the report identifies those who gain and those who lose from intervention and measures the extent of the gains and losses. While details of the calculations and concept are quite complex, the basic proposition is that if a government intervention, say an export tax, causes the domestic price of a commodity to fall, then several effects result. First, producers respond by producing a smaller quantity. Since both quantity and price have decreased, then farmers' iacome will decrease. They "lose" from the intervention. Second, lower prices cause consumers to consume more. Since for the same expenditure they can now purchase more than before, this is equivalent to an Increase in their income. They "win" from the inter- vention. Third, the government earns revenue from the tax. That is, govern- ment "income" increases. They are also "winners" from the intervention. Thus far the net effect of the intervention is that income has been transferred from farmers to consumers and government. But there are further effects. Exports and therefore export earnings fall as production falls and domestic consumption increases. Agricultural employment declines in response to lower output. Finally, the imposition of a tax causes a so-called "deadweight loss" (a net ioss of national income) to the economy as a result of operating at a less than optimal level of output. These rather difficult concepts are explained in further technical detail in Annex 3 of Volume II. F. Domestic Resource Costs 2.08 To investigate the relative efficiency of various agricultural activities and manufacturing industries in the Philippines and to judge their international competitiveness, the report makes use of the concept of "domes- tic resource costs" (DRCs). An industry's DRC represents the cost of domestic resources used per unit of foreign exchange earned or saved when domestic resources are valued at their true value in the economy, which may differ from their current market value. If there is a disparity among DRCs across econ- omic activities, a reallocation of domestic resources to the 'Lower DRC (more  - 7 - efficient activities) would generally result in higher total output and therefore higher national income. Thus the D1C calculaiion shows an activ- ity's "internal foreign exchange rate." Activities with "internal exchange rates" lower than the shadow rate for the country would reveal activities which should be encouraged, since they can earn foreign echange at a cost better than the national average (represented by the shadow excharLge rate). 2.09 DRCs are used here for two purposes. First, as a measure of the relative efficiency of resource allocation within the Philippine economy, and second as a measure of the international competitiveness of various industries (including agricultural industries). These two uses of DRCs respond to two questions frequently raised in policy dialogues with developing country deci- sion-makers. First, it is often asserted that in the real world policy-makers have no choice but to promote individual priority industries by' differential incentives. The economic policy analyst then must question whether those industries favored by the policy deserve the special incentives. Are they using domestic resources efficiently or is there a better use of these resour- ces in the economy? 2.10 Second, it is frequently claimed by those who receive special treatment that removal of the incentives, protection, or subsidy would result in their industry being drowned by international competition. The DEC measure provides an indication of the robustness of the industry vis-a-vis similar industries in the rest of the world. The DRC is therefore a very useful tool of analysis in formulating policy advice. G. Limitations of the Analysis 2.11 As with all constructs in economics, the methods described and used here have numerous assumptions and limitations, the importance of which need to be assessed in qualifying the conclusions. These asswmptilons and limitations are now explicitly described. 2.12 The first problem is one of choosing an appropriate border price from which coniparisons can be made. International prices fluctuate for all commodities. For some, such as sugar and rice, the annual average fluctuation in world price may be in excess of 20% per year. In such cases, it is likely that domestic prices will exceed world prices in some years and be below them in otlhers. The usual solution to this problem is to use its trend value at any point in time. The value used in this analysis is calculated for key commodities by the Economic Analysis and Projections Departnent of the World Bank. 2.13 A second problem concerns the accuracy of the estimates of supply and demand elasticities and of the shadow exchange rate. The analyst nust satisfy himself that the values being used are the best available. In this case elasticities include cross-price terms and have been carefully calculated in some cases by several researchers; therefore, the elasticity estimates can be used with considerable confidence. Likewise the formal shadow exchange rate calculation, while now dated, represents a very careful attempt to pro- vide the best estimate of that value under the stated assumptions.  - 8 - 2.14 There are some more fundamental assumptions that are made in the analysis. First, the welfare analysis assumes that world prices will be unaffected by output changes in the Philippines. This is the so-called "small country assumption," For many products the assumption is valid. For other commodities such as sugar and copra and its products, where the Philippines is a major exporter, changes in its output could conceivably alter world prices. However the small quantities involved here, the elasticity of world demand faced by the Philippine and the small part of the world market for oils and meals that Philippi:es copra accounts for, make the assumption tenable. Second, the approach is a partial equilibrium, comparative, static one. Some cross-product effects arc ignored and the dynamic aspects in growth and output cannot be captured. The analysis provides "snap-shots" of the sector under various conditions rather than a "movie" of its possible evolution. 2.15 Having said this, the analysis is still valid and useful for policy- making. The method of analysis Is helpful in showing general directions in which medium- to long-run policy should move. The Bait is confident in the validity of the report's conclusior's as applied to the Philippine economLc situation. In some cases such as those recommendations on general aacro-eco'- nomic policies (e.g. levels of protection between the industrial and agricul- tural sectors) there is a high degree of confidence that a plan of action can be mapped out for the formulation and implementation of pricing policy. In other cases such as commodity specific interventions (e.g. import monopsony on feed grains and oilseed meal and rice exports) evidence suggests a clear direction in formulating a pricing and marketing policy, but certaln details on the alternatives ava'lable to policy-makers need to be determined. And in still other cases (e.g. coconuts and sugar) more detailed and comprehensive studies are required before a plan of action can be implemented. Also caution needs to be exercised in interpreting the numbers that are produced. They should not be taken too literally. While our best estimate, using this methodology, of the loss of foreign exchange due to copra policies, for example, is P 1.15 billion, the best interpretation of this would be to say that the annual loss of foreign exchange due to copr.a policies is large and significant. III. MAJOR INTERVENTIONS IN AGRICULTURE: THE PRESENT POSITION A. Macro Policy Instrutuents 3.01 Most macro-policy inscruments used in an economy have a rather uni- form effect across all sectors of the economy and are therefore not of special interest to agriculture. For example the personal incomie tax rate applies more or less equally to agriculture, processing, manufacturing and the service sectors of the economy. Thus while this intervention can be said to be a dis- incentive to production it operates fairly equally across the economy and therefore does not cause a misallocation of resources among productive uses. However, the effects of some macro-policies are particularly important for the agricultural sector.  - 9- The Exchange Rate and the Trade Regime 3.02 'The agricultural sector has a large stake in both exports and imports. The amount of pesos it receives from export sales, and the peso cost of imports, clearly depends on the official exchange rate. Under the exchange-rate regime in effect for many years, the country has had a common rate applicable to all types of transactions. Thuis the exchange rate has not discrinilnated against certain sectors in favor of others, although it may in fact have benefited some sectors more than others as a result of the different degrees to which they sold or purchased abroad. This study has not looked into that question, nor has it concerned itself with the question of whether or not the peso has been overvalued during the past decade or so, in the sense that Government decisions have fixed the exchange rate at a level different from the free market rate. 3.03 But the official exchange rate is not the only type of Government intervention that determines how the various sectors are affected by foreign trade. Of equal importance, perhaps, is the structure of government interven- tions directly affecting foreign sales and purchases, interventions commonly called the "trade regime." This study has been interested In this set of interventions, from two points of view. One viewpoint has been to estimate whether the country's trade regime appears to have favored, or discriminated against, agriculture vis-a-vis other sectors, notably manufacturing. This could happen, for exaiple, if agricultural producers were required to pay export taxes which other sectors did not pay, or had to pay higher tariffs on their imports, or were denied access to foreign markets by trading restric- tions that did not apply to other sectors. The second question we have asked of the trade regime is whether it has resulted in export or import prices for agriculture significantly different from what they would have been under some "optimum" trade regime (i.e. some agreed minimal set of interventions, although not necessarily the complete absence of all interventions). Since the effect of trade interventions is to change the revenue and costs of pro- ducers, and to influence their economic behavior accordingly, the result has much the same effect as if their foreign transactions were subject to an exchange rate different from the official rate. 3.04 This study has used research by local scholars to estimate the degree to which the country's trade regime has put agricultural producers at a handicap in their foreign transactions and to estimate the impact of these trade handicaps on the allocation of resources to the sector and on the wel- fare of gfricultural producers and consumers. Using 1974 input-output data, Medalla - estimated the shadow exchange rate with three different nethods and assumptions: the UNIDO method, the Bacha-Taylor method using the free trade assumption, and a modified method by Redalla that is based on an assumed sys- tem of "optimal" trade intervention. This report is based on the approach 4/ See E.M. Medalla, "Estimating the Shadow Exchange Rate Under Alternative Policy Assumptions," in Industrial Promotion Policies in the Philippines by R.N. Bautista, John Power and Associates, PIDS, Manila, 1979, p. 81-110.  - 10 - proposed by Medalla, not on a completely free trade assumption. Medalla compares the current system of interventions with a projected "optimal" trade regime. The rationale for the latter is the existence of market failures and externalities that can be corrected with various measures that have only small distorting trade effects, and minimal costs to the overall economy. The shadow exchange rate for such an "optimum" regime was calculated to be around 1.2 of the nominal rate. Based on Medalla's work one can state that the trade intervention measures used in 1974 resulted in an overvaluation of the exchange rate by roughly 20%. Because this overvaluation Is caused by trade measures it Is not affected by changes in the nominal exchange rate. The net effect of an overvaluation induced by commer-cial policy is the same as if the nominal exchange rate itself were overvalued: exports are lower and imports higher than they would be under an "optimum" trade regime. Industrial Policy 3.05 Much has been written both Othin and outside of the World Bank on industrial policy in the Philippines._ Yet in large part the spillover effects of industrial policy onto agriculture have received scant attention. The high levels of protection and the resulting incentives provided by indus- trial pricing policy are in sharp contrast to the low levels of protection and the resulting disincentives in agriculture. The disparities have caused a misallocation of resources into activities which are not competitive. 3.06 The generous incentives offered to Industrial investments over the 1970s, such as accelerated depreciation, carryovers of losses, tax exemption on imported equipment, tax credits on domestic equipment, tax deductions for expansion, and the additional incentives offered to "pioneer" enterprises such as exemption from all taxes except income tax and tariff protection, had the effect of making capital more abundant and profitability higher than would otherwise result. The effect of this was to accelerate the movement of pro- ductive resources away from agriculture. To the extent possible the effects of the biased treatment of manufacturing versus agriculture are quantified in Chapter IV assuning a commercial regime existing in 1982 but presently undergoing staged reforms. 3.07 Since 1980, major changes in the Philippines' trade regime have been introduced which will reduce significantly the bias of the country's protec- tion system against agricultural production in general and agricultural exports in particular. In 1980, the Government formally announced a new industrialization strategy which seeks to develop an industrial structure that is based on the country's comparative advantage with respect to labor costs and raw material availability and which is efficient and competitive by inter- national standards. It includes staged reforms over an initial period of five 5/ The World Bank has reviewed industrial policies and performance in Philippines Industrial Development Strategy and Policies, October 1979 (Report No. 2513-PH); Structural Adjustment Loan 1, August 21, 1980 (Report No. P-2872-PH); Structural Adjustment Loan II, April 1, 1983 (Report No. 3389-PH).  - 11 - years designed to correct the import-substitution and capital-intensive bias of existing industrial and trade policies. The program includes a major realignment of the tariff system, liberalization of quantitative import restrictions and changes in the exchange rate policy. 3.08 The tariff-reform program, which covers gradual tariff changes over a period of five years (1981-85), will lower the overall level of protection in the economy (particularly in the industrial sectorj and even out the spread in tariff rates within and betweea sectors. Peak tariff rates for all imports have already been reduced from 70% and 100% to a ceiling rate of 50% in two steps: on January 1, 1981 and January 1, 1982. Further realignment to achieve greater uniformity in protection will be completed on January 1, 1985. By 1985, the tariff adjustments will reduce the average effective protection rate (EPR) for the manufacturing sector from 44% to 29% and will also lessen the degree of escalation in the structure of protection for raw materials, intermediate products and finished goods. Thus the bias against agriculture will be substantially reduced when the policy package is fully implemented. B. Product-Specific Interventions 3.09 In this section government policies toward major agricultural products are described as they currently (1983) exist. The background to evolution of the policies will be found in the relevant Annexes in Volume II. Only an outline of present interventions is presented here. Rice 3.10 The National Food Authority (NFA) reguLates the rice market by setting floor and ceiling prices for rice in consultation with other official bodies. It defended these prices by (until 1983) retaining a monopoly on international trade and in its domestic market operations. In its early years, when the Philippines was a rice importer, NFA (then National Grains Authority) was in the position of defending the ceililg price by regulating the flow of imports. Now with production usually exceeding consumption at existing prices its principal activity is to defend the floor price by exports and stockpiling. Financing for its activities comes from three major sources -- subsidized lineb of credit from government-owned banks; the public budget; and internally generated funds coming from its position of sole buyer and seller of wheat, soybean meal and imported corn in the Philivpities and from licensing fees. See Annex 4 for details on NFA. 3.11 In order to defend the official price NFA attempts to purchase approximately IOZ of the rice crop. It has managed to achieve this share of output, but private discounting at peak production times is still widespread and accepted. Often, when warehouses are full or NFA experiences cash-flow problems, they cannot purchase rice from farmers at the official floor  - 12 - price. Farmers, therefore, often liquidate their crop at a discount to private buyers (from whom they may have obtained credit) rather than wait until the situation changes. 3.12 These interventions by the NFA do not necessarily distort production patterns since the average level at which prices of rice prevail in the market is the imaportant determinant. In fact, on average, the domestic price of rice in the Philippines in recent years lhas approximated the border price. Even so rice exports were unprofitable at existing exchange rates prior to mid-1983 because Philippine rice did not meet standards which attracted a quality premium. Domestic millers were not provided the incentive to develop internationally acceptable quality standards because private exports had been restricted. Recently NFA announced that it will allow private exports of rice. This should provide some stimulus to the milling industry and should allow quality differentials for different types of rice to emerge. It should also partially remove the burden of storage from the NFA since some stocks which would otherwise be held from time to time would be sold on the export market. These issues must be viewed In the context of the Philippines being a marginal and intermittent rice exporter, and that exportable rice surpluses may disappear if current plans for diversification are successful. 3.13 The issue of rice quality is widely acknowledged in the Philippines. The problem is far from intractable and may be easily explained in terms of the fact that the Philippines has only recently been transformed from a rice importer to rice exporter. There is no long-standing tradition of contact with the international market as a seller of rice. It will take time to make trade contacts, establish a reputation, and develop the necessary domestic prerequisites to be a rice exporter. NFA's limited moves toward relaxing government's monoply on international rice trading and in setting domestic prices close to world prices are moves in the right direction (Annex 4, para. 10). 3.14 The largest source of government intervention in rice has been the provision of irrigation. The Government bears all investment costs and some operating costs of irrigation. Ihis subsidy increases the profitability of rice production for farmers with irrigation. 3.15 Credit subsidies for rice production, while lowering interest rates substantially from formal credit rates, are so small in volume that they are not considered a significant distortion. 3.16 Offsetting the subsidized price of irrigation are higher-than-border prices for fertilizer, machinery, farm chemicals, and fuel. Xs a result, the net effect is that prices received by producers Df rice are very close to the world price. Nonetheless, rainfed farmers, who do not benefit from irrigation subsidies but are burdened by the higher prices of other inputs, are on bal- ance slightly penalized and somewhat disadvantaged relative to irrigated rice farmers.  - 13 - Corn 3.17 There are two types of corn grown and used in the Philippines. White corn is used for human consumption and can be used in animal feed. Yellow corn is used exclusively for animal feed. White corn accounts for about 75% of total corn production, but production of yellow corn is growing at (18% p.a.), approximately three times the rate of white corn. Because of the dual use of corn as a final good for lower income consumers and as an intermediate input to livestock consumed raainly by higher income groups, the Government intervenes in the market on the basis of safeguarding social equity. As for rice, subsidized credit is made available in corn production programs, but the important interventions are through monopolization of corn imports (yellow corn) and corn price controls. Domestic prices have been above border prices for over 20 years; recently the gap has been gradually closing, although the domestic price is still more than 20% above the border price. The NFA has responsibility for importing corn and for supporting a target price by purchasing corn from farmers at that price. It then sells to compounders, millers, and integrated livestock operations. Some farmer sell privately at a discount to middlemen from whom they may have obtained credit. Sugar 3.18 Sugar is a traditional major earner of foreign exchange in the Philippine economy and until 1974 almost all exports were sold in the protec- ted U.S. market. Since then the government has heavily controlled the sugar industry and sugar marketing on the grounds that it is necessary to protect producers and consumers from world price fluctuations, and that a single trading entity has greater marketing power in the global arena. Regulations include export taxes, import bans, price controls, marketing controls, special treatment under minimum wages legislation, and low-interest rates on loans. From 1S74 to 1984, a single buyer of sugar from sugar mills, also the sole exporter, was allowed. The policymaking body is Philsucom (the Philippine Sugar Commission) and commercial operations are handled by Nasutra (the National Sugar Trading Corporation). 3.19 It has been estimated that, over the period 1974-82, producers received only 77% of the world price of sugar while domestic consumers paid only 69% of the world price. These averages conceal large fluctuations in protection and implicit taxation induced by the traditional erratic price movements of sugar on the international market. Producer and consumer prices were above border prices for three of the seven years, and producer prices again exceeded border prices in 1983. 3.20 Philsucom allocates sugar production to export, consumption and reserves and fixes the raw sugar buying price on the basis of the average of liquidation price on the domestic market (which price it determines) and the export markets. Holding the domestic price of sugar well below export prices in earlier years, in effect subsidizing consumers at the expense of planters who received less than the world market price, probably adversely effected  - 14 - production in a sector with excess processing capacity. lowever, an increase in domestic prices was ordered in Narch 1982 and currently export and domestic prices are roughly in line. 3.21 About 14 new mills were built between 1970 and 1974 with loans guaranteed by PNB and DBP and overall there is excess capacity; nevertheless, some new investment i